Incumbent Lenders Research Articles

Trust As an Entry Barrier: Evidence from FinTech Adoption

This paper studies the role of trust in incumbent lenders (banks) as an entry barrier to emerging FinTech lenders in the credit markets. The empirical setting exploits the outburst of the Wells Fargo scandal as a negative shock to the trust in banks. Using a difference-in-differences framework, I find that increased exposure to the Wells Fargo scandal leads to an increase in the probability of borrowers using FinTech as mortgage originators. Utilizing political affiliation to proxy for the magnitude of trust erosion in banks in a triple-differences specification, I find that, conditional on the same exposure to the scandal, a county experiencing more trust erosion has a larger increase in FinTech share relative to a county experiencing less trust erosion. Treatment effect heterogeneity estimation from generic machine learning inference suggests that trust is less critical in FinTech adoption for the African American borrowers.

Carrot or Stick? Evidence from a Pair of Randomized Field Experiments Testing Lender Information Sharing Hypotheses

Using two randomized field experiments, we examine how warning borrowers that their loan performance will be reported to a public credit registry affects their loan take-up and repayment decisions. We show that credit warnings increase loan take-up rates. The main drivers appear to be anticipation of reduction in incumbent lenders’ informational rents and improvement in access to informal or formal credit. Moreover, credit warnings reduce default rates by 3.7–5.9 percentage points. This reduction is comparable for borrowers who receive the credit warning before and after the loan take-up, which suggests that credit warnings have little net effect on borrowers’ credit-risk composition due to selection.

Asset-Based Lending

Asset-based lending, the supply of loans based on floating collateral, is an important source of funding for small firms. We analyze the effect of competition on asset-based loan markets on interest rate distributions and the mobility of small firms. Close monitoring of collateral by lenders results in an informational advantage for the incumbent lender and third-degree price discrimination. We find that adverse selection results in a unique equilibrium in which lenders randomize interest rates and firms switch lender with positive probability. Increased competition between lenders does not benefit firms through lower expected interest rates, neither does it improve their mobility.

Information Sharing, Holdup, and External Finance: Evidence from Private Firms

Abstract To mitigate holdup by an informed incumbent lender, a private borrower may publicly share information in order to increase lender competition. Despite proprietary costs, a subset of private borrowers voluntarily share private information in loan and credit underwriting agreements. These borrowers switch lenders at a 16% higher rate and receive lower loan financing costs. For private firms that go public, we analyze changes in the net benefits of information sharing and study the potential estimation bias from unobservable borrower quality. This setting corroborates our inference that voluntary information sharing reduces lender holdup and alleviates financial constraints for private firms. Received May 25, 2017; editorial decision August 8, 2018 by Editor David Denis.

Information Advantage, Relationship Advantage and Competition in Banking

I study competition among asymmetrically informed lenders in loan markets. In the past few years, a new competitor called FinTech emerges in financial markets. In loan markets, an important feature of FinTech companies is that they can acquire information about borrowers’ characters, that incumbents have not acquired. This leads to an information advantage for FinTech. On the other hand, the incumbent lenders have to different advantage based on relationship with the borrowers. Thus, both types of lenders compete by using their own advantages. I find that as the results of the competition, both lenders can earn positive profit by using their respective advantages. I show, among others, that comparing with the competition between two incumbent lenders, the competition between the incumbents and FinTech improves social welfare without decreasing their profit.

Crowding Out Banks: Credit Substitution by Peer-To-Peer Lending

Through superior technology, financial technology (FinTech) firms may expand credit markets. Alternatively, consumers may substitute one credit provider for another, generating adverse selection problems for incumbent lenders. We analyze the unsecured consumer loan market and identify the influence of FinTech lending on commercial banks using a novel approach that takes advantage of regulatory restrictions for FinTech borrowers and investors. We show that high-risk FinTech loans substitute for bank loans while low-risk loans may be credit expansionary. However, the influence on banks is heterogeneous. Our results highlight the changing landscape of financial intermediation and the regulatory challenges faced by FinTech firms.

Does Competition Reduce Racial Discrimination in Lending?

This paper examines whether increases in bank competition reduce discriminatory practices in mortgage lending. Lenders are significantly less likely to approve black applicants' loan applications despite facing similar credit risk. However, following the relaxation of interstate bank branching laws in the 1990s, increases in local lending competition reduced the approval differential between potential white and black borrowers by roughly one quarter. The reduction was driven both by incumbent lenders altering lending policies to avoid losing market share and by the entry of new banks. The results suggest strong complementaries between direct regulation and the competition mechanism. In particular, direct regulation is effective against large lenders where statistical proof problems are less severe, while competition provides incentives to smaller, harder to regulate lenders.

Lending to uncreditworthy borrowers

We study optimal lending behavior in situations where borrowers’ outside options increase with their creditworthiness. Creditworthiness is private information of borrowers. Lenders use collateral as a screening mechanism to address this adverse selection problem. A lender seeking to attract creditworthy borrowers with high reservation payoffs (while screening out uncreditworthy types) must offer contracts with sufficiently low interest rates and, consequently, high collateral requirements. Because higher collateral requirements raise screening costs, however, lenders favor pooling uncreditworthy borrowers over screening them—in essence, a lowering of credit standards. Lending costs determine break-even offers that rival incumbents can offer borrowers. Accordingly, a lender faces borrowers whose reservation payoffs depend on the lender’s cost advantage over rival incumbent lenders. Our results imply that screening is more likely to occur in markets with a greater disparity in lending costs. Conversely, when funding markets are intensely competitive, lenders are more likely to resort to pooling. This paper also rationalizes the phenomenon of cream-skimming by outside (foreign) lenders as an equilibrium of the model. Surprisingly, we find that the presence of an informed rival actually facilitates cream-skimming by an uninformed lender.

Liquidity Risk, Credit Risk and Interbank Competition

This paper examines the impact of interbank competition on liquidity risk and on the interaction between liquidity and credit risks. We first show that financial intermediation with deposit insurance may increase the impact of liquidity risk, so that intermediated loans may carry higher liquidity premia for borrowers than market-financed loans. Second, with negligible interbank competition, higher credit risk may reduce liquidity risk, so a bank's need for liquidity may also induce it to take on additional credit risk. Third, we show that Bertrand competition among banks in the loan market, introduced by outside lenders purchasing the relationship-specific liquidation skilll of the incumbent lender, has two potential effects: (i) it can improve loan liquidity, and (ii) it can make credit and liquidity risks comonotonic, thereby reducing the inclination of banks to take on excessive credit risk to cope with their liquidity needs. However, interbank competition improves loan liquidity only under some conditions. We identify conditions under which greater interbank competition increases loan liquidity and reduces each bank's overall risk, which includes credit and liquidity risks.

‘Irresponsible Lending’ with a Better Informed Lender

We present a simple model of personal finance in which an incumbent lender has an information advantage vis-a-vis both potential competitors and households. In order to extract more consumer surplus, a lender with sufficient market power may engage in 'irresponsible' lending, approving credit even if this is knowingly against a household's best interest. Unless rival lenders are equally well informed, competition may reduce welfare. This holds, in particular, if less informed rivals can free ride on the incumbent's superior screening ability. This article proposes a new framework for analysing household (or consumer) lending. Using its past experience with borrowers in the same local area or borrowers facing similar economic conditions, a sophisticated lender may often have a better estimate of a household's default probability than the household itself. I derive the conditions where such information asymmetry can lead to 'irresponsible' (or 'too aggressive' lending), in which case credit is approved even though this is knowingly against a household's best interest. Admittedly, the more standard approach is to assume that borrowers represent the better informed party. While we do not want to dismiss the importance of borrower adverse selection, the presumption that sophisticated and experienced lenders can estimate the default probability better than individual borrowers may be particularly suitable if borrowers are households. Individual households may not have statistically accurate information about the likelihood of, say, losing their job in an economic downturn or of incurring large medical bills in the future, both of which may cause them to default on a loan. On the other hand, we do not presume that households' own estimates are biased on average. I borrow the assumption of 'informed lending' from Inderst and M?ller (2006), where a lender is better informed about the expected cash flow from a newly financed project. My current analysis is tailored, instead, towards household finance and my focus is on whether too aggressive lending can occur in equilibrium. This focus is motivated by the particular attention that policy makers have given to this issue. For instance, in the UK various reports and taskforces on consumer lending practices (and, more generally, on the surge of household debt) have brought up

Lending to Uncreditworthy Borrowers

We study optimal lending behavior in situations where borrowers’ outside options increase with their creditworthiness. Creditworthiness is private information of borrowers. Lenders use collateral as a screening mechanism to address this adverse selection problem. A lender seeking to attract creditworthy borrowers with high reservation payoffs (while screening out uncreditworthy types) must offer contracts with sufficiently low interest rates and, consequently, high collateral requirements. Because higher collateral requirements raise screening costs, however, lenders favor pooling uncreditworthy borrowers over screening them —-- in essence, a lowering of credit standards. Lending costs determine break-even offers that rival incumbents can offer borrowers. Accordingly, a lender faces borrowers whose reservation payoffs depend on the lender’s cost advantage over rival incumbent lenders. Our results imply that screening is more likely to occur in markets with a greater disparity in lending costs. Conversely, when funding markets are intensely competitive, lenders are more likely to resort to pooling. This paper also rationalizes the phenomenon of cream-skimming by outside (foreign) lenders as an equilibrium of the model. Surprisingly, we fi nd that the presence of an informed rival actually facilitates cream-skimming by an uninformed lender.

Equilibrium Default Cycles

This paper analyzes Markov equilibria in a model of strategic lending in which (i) agents cannot commit to long‐term contracts, (ii) contracts are incomplete, and (iii) incumbent lenders can coordinate their actions. Default cycles occur endogenously over time along every equilibrium path. After a sequence of bad shocks, the borrower in a competitive market accumulates debt so large that the incumbent lenders exercise monopoly power. Even though the incumbents could maintain this power forever, they find it profitable to let the borrower regain access to the competitive market after a sequence of good shocks. Equilibria are computed numerically, and their attributes are qualitatively consistent with numerous known empirical facts on sovereign lending. In addition, the model predicts that a borrower who accumulates debt overhang will regain access to the competitive credit market only after good shocks. This prediction is shown to be consistent with data on emerging market economies.

Foreign Lenders and the Real Sector

We develop a theory of the interaction between the entry of lenders and the real sector. The high liquidation skills of incumbent lenders render them too tough in terminating high‐risk/return projects. Being “foreign” to the market, newcomers have lower ability to liquidate than incumbents. This makes them softer in liquidating high‐risk/return projects but renders their funding more costly. We show that the entry of lenders and the share of high‐risk/return projects can reinforce each other through firms' liquidation values. This interaction dampens the output impact of liquidity shocks. Hence, financial liberalization can enhance stability.

Lending Competition, Relationship Banking, and Credit Availability for Entrepreneurs

Existing theories consistently predict that relationship banking enhances credit availability for new firms. To put more concretely, these theories predict that soft information acquisition about borrowers' creditworthiness and the resulting incumbent lender's profit-improving and relation-specific consulting ability yield a monopolistic rent for the incumbent lender, and that this expected rent encourages a bank to lend to younger firms to pre-empt an exclusive relationship ahead of rival banks. The present study tries to provide evidence for this hypothesis using a dataset collected from the 2003 Survey of the Financial Environment of Enterprises in Japan. Our statistical analysis shows that the time interval from start-up to the first loan approval for a firm is shorter if a bank intends to undertake relationship banking, even after controlling fund-demand and creditworthiness factors of each firm. This result provides evidence to support the above hypothesis. Our logit analysis shows that the probability for banks to undertake relationship banking is decreasing or hump-shaped against the number of competing banks. Thus, the increase in the number of competing banks is more likely to discourage these banks from providing relationship banking, and this in turn diminishes credit availability for new firms. Besides such an effect arising from relationship banking, the data shows evidence suggesting the statistical significance of another mechanism generating a negative correlation between the number of competing banks and credit availability for new firms, which may be explained by the theory of winner's curse. As a whole, credit availability for new firms was higher in more concentrated local credit markets in the last fifteen years in Japan.

'Irresponsible Lending' with a Better Informed Lender

We present a simple model of personal finance in which an incumbent lender has an information advantage both vis-a-vis potential competitors and households. We show how in order to extract more consumer surplus an incumbent with sufficient market power may optimally engage in irresponsible lending, approving credit even against a household's own best interest. To extract more surplus, the incumbent may even make a (cash) advance above the value of the purchased good. We also show that increased competition that does not level out the information asymmetry between the incumbent lenders and its competitors may not always increase welfare, in particular if less informed lenders can free ride on the incumbent's superior screening ability.

Entry and Strategic Information Display in Credit Markets

In many countries, lenders voluntarily provide information about their borrowers to private credit registries. A recent World Bank survey reveals that the display of a lender’s own borrower information is often not reciprocated. That is, access to these registries does not require the prior provision of proprietary data. We argue that incumbent lenders release information about a portion of their profitable borrowers for strategic reasons. The reasoning is that the pool of unreleased borrowers becomes characterised by a severe adverse selection problem. This prevents the entrants from bidding for all the incumbent’s profitable borrowers and reduces their scale of entry.

On the sequencing of projects, reputation building, and relationship finance

We study the decision an entrepreneur faces in financing multiple projects and show that relationship financing will arise endogenously in an environment where strategic defaults are likely, even when firms have access to arm's-length financing. Relationship financing allows an entrepreneur to build a private reputation for repayment that reduces the cost of financing. However, in an environment where the risk of strategic default is low, the benefits from reputation building are outweighed by holdup rents extractable by the incumbent lender. Entrepreneurs then choose to finance projects from single or multiple, arm's-length lenders. We relate these findings to studies that positively associate accounting standards, creditor rights, and legal enforcement with economic growth.

How Rising Competition among Microfinance Institutions Affects Incumbent Lenders

This article uses data from Uganda’s largest incumbent microfinance institution to analyse the impact of entry by competing lenders on client behaviour. We observe that rising competition does not lead to an increase in client dropout rate, but induces a decline in repayment performance and savings deposited with the incumbent, suggesting rising multiple loan‐taking by clients. This joint effect on dropout and repayment is consistent with some negative information about clients and is being shared across lenders. However, the observed decline in repayment rates in a context of rising multiple loan‐taking shows that information sharing about clients is far from complete.

Small Banks, Small Business, and Relationships: An Empirical Study of Lending to Small Farms

We examine small banks’ lending to small farms. We find that relationships, as measured by the length of tenure of farm operators, are positively related to bank lending. We also find that de novo banks have a positive tendency to lend to small farms. When existing relationships between borrowers and incumbent lenders are stronger, de novo banks have greater difficulties in lending to small farms. We further find that, even within the category of small banks, lending to small farms (as a percentage of a bank’s assets) tends to decrease as the bank increases in size.

Contemporary Issues in Regulatory Risk Management of Commercial Banks

Banks are unique economic entities primarily due to their ability to create money, and the impact that bank information production and liquidity services have on the real economy. The origin of bank regulation in the U.S. is often viewed as a manifestation of the ‘‘free banking’’ period prior to the middle of the 19 century. In the absence of regulation banks could create violent swings in the amount of money created and therefore have real effects on business activity and prices. In addition, banks of that time were often inadequately capitalized due to excessive dividends and/or the prevalent practice of contributing capital in the form of promissory notes. Banking of the era was further characterized by speculative loans and inadequate liquidity. Government regulation was seen as the answer to bank panics and subsequent recessions. The traditional theory of financial intermediation identified a critical function of commercial banks as the transformation of the financial contracts that borrowers (i.e., people and firms that need money but don’t have it) prefer to issue into the contracts that savers (i.e., people and firms who have money but don’t immediately need it) prefer to hold. More recent theories have stressed the role of delegated monitoring in shaping the assets in which banks invest and the role of liquidity services in shaping the liabilities that banks issue. A detailed review of the theory of financial intermediation is beyond the scope of this study. It is important to note, however, the theoretical foundation for the systemic high leverage in the banking industry. Diamond and Rajan (1998) do so. In their model savers need liquidity because they are uncertain about when they will need to sell a financial asset and borrowers need liquidity to meet unanticipated funds needs and also because they may not be able to retain current funding in the future. The authors argue that the real problem is neither borrowers nor lenders can commit future human capital to the savers and therefore both real assets and financial assets are illiquid. The real assets cannot be sold for the full value of the potential cash flows because the entrepreneur may be absent. In the same vein, incumbent lenders can obtain more for real assets that come under their control than any third-party simply selling the